Working Capital Management

1

• Chapter 22
• Working Capital Management

2
WORKING CAPITAL THEORY AND POLICY

• Working capital management is important because
• it typically requires a _____ investment than in
  fixed assets
• it requires _____ management

3
CASH CONVERSION CYCLE

• The cash conversion cycle (CCC) is a _____
  representation of the working capital
  process.
• The CCC is the time between when _____ is made to
  suppliers and when _____ is received from
  customers.
• The CCC is a _____ gap that must be funded.

4

• The CCC is calculated from _____
  components.
• The _____ is the average time between when raw
  materials and labor are acquired, and when a
  finished product is completed and sold.

5

• The _____ is the average time between when a sale
  is made, and when collection occurs.
• The _____ is the average time between when raw
  materials and labor are acquired, and when
  payment is made to suppliers and labor.

6
Example

• Determine the cash conversion cycle for the Jones
  Company
• Sales 10,000,000
• Cost of goods sold 8,000,000
• Receivables 657,534
• Payables 657,534
• Inventories 2,000,000

7

• How would the conversion cycle for the Jones
  Company be illustrated in a diagram?
• 73 days 24 days
• 30 days _____ days

8
In-Class Exercise

• Determine the cash conversion cycle for the Smith
  Company
• Sales 730 million
• Cost of goods sold 438 mil.
• Receivables 73 million
• Payables 109.5 million
• Inventories 146 million

9
Observations on the CCC

• We should prefer that the cash conversion cycle
  to be _____.
• In terms of the CCC, we strive to
• shorten the _____
• shorten the _____
• increase the _____

10

• How can the inventory conversion period be
  shortened?
• - _____ efficiency in production
• - _____ the average inventories in stock thru
  just-in-time or other methods
• - produce items by _____ so finished goods can
  be shipped out _____ upon completion (like Dell)

11

• How can the collection period be shortened?
• - change terms to a _____ net date
• - _____ controls on late payments
• - batch receivables _____ frequently

12

• How can the payable deferrals period be
  lengthened?
• - negotiate _____ payment terms with suppliers

13
The Connection Between CCC and EVA

• There is a connection between the cash conversion
  cycle (CCC) and economic value added (EVA).
• The inventory conversion period can be reduced by
  _____ the average amount of inventories held in
  stock, which then _____ net operating working
  capital and operating capital, which then _____
  both free cash flow and economic value added.

14

• ?Inv ?NOWC (Rec ?Inv) (Pay)
• ?OpCap ?OpCap ?NOWC FA
• ?EVA ?EVA NOPAT - ?OpCap
• Also ??OpCap ?OpCap OpCapLastYear
• ?FCF NOPAT - ??OpCap

15

• Likewise, the receivables collection period can
  be reduced by reducing time to collection of
  receivables, which then reduces net operating
  working capital and operating capital, which then
  increases both free cash flow and economic value
  added.

16

• ?Inv ?NOWC (?Rec Inv) (Pay)
• ?OpCap ?OpCap ?NOWC FA
• ?EVA ?EVA NOPAT - ?OpCap
• Also ??OpCap ?OpCap OpCapLastYear
• ?FCF NOPAT - ??OpCap

17

• Finally, the payables deferral period can be
  increased by increasing time to payment to
  suppliers, which then reduces net operating
  working capital and operating capital, which then
  increases both free cash flow and economic value
  added.

18

• ?Inv ?NOWC (Rec Inv) (?Pay)
• ?OpCap ?OpCap ?NOWC FA
• ?EVA ?EVA NOPAT - ?OpCap
• Also ??OpCap ?OpCap OpCapLastYear
• ?FCF NOPAT - ??OpCap

19
The Master of the CCC Dell Corp

• 1999 2001 2003
• InvConvPd 7.1 5.8 3.9
• RecCollPd 49.6 33.1 26.7
• PayDefPd 62.3 62.1 75.8
• CCC -5.6 -23.1 -45.3
• Note how the CCC _____ tremendously over time
  (huge improvement!)

20

• The negative value for the CCC for Dell means
  that working capital is actually a _____ of funds
  rather than something that must be funded.
• The continued drop in the CCC over time means
  that this source of funds was actually _____ over
  time.

21
ALTERNATIVE WORKING CAPITAL POLICIES

• Not all companies follow the same working capital
  policy.
• A relaxed w/c policy employs _____ NOWC and a
  greater portion of the debt is _____-term.
• An aggressive w/c policy employs _____ NOWC and a
  greater portion of the debt is _____-term.
• The aggressive policy is _____, but more _____.

22

• Working capital management, by definition, refers
  to managing the working capital accounts
  current asset accounts and current liability
  accounts.
• The following is a sampling of some of the
  techniques used in managing of those accounts.

23
CASH MANAGEMENT TECHNIQUESSynchronizing cash
flows

• Assume a firm
• - disburses 28 mil weekly to regional offices
• - offices use cash for transactions evenly
  throughout the 7-day week
• - distributing cash daily would cost another
  200,000 in admin. fees
• - interest rate on short-term loans is 10

24
Should they switch to daily disbursements?
Values are in millions
28
avg. idle cash 14
4
avg. idle cash 2
7 days 14 days
25
Lock-box systems

• A firm has west coast customers
• - 18.25 million annual sales (terms net 30)
• - 6-day mailing/check-clearing delay
• - a lockBox would cut delay by 2 days, but cost
  12,000/year
• - i-rate on short-term loans 12
• Should they switch to using lockboxes?

26
SHORT-TERM INVESTMENTSMARKETABLE SECURITIES

• Companies hold marketable securities as a form of
  _____ cash.
• Marketable securities have
• - _____ maturities
• - an active _____ market
• - low risk of _____
• - low _____

27

• Instruments that are appropriate for marketable
  securities investment include
• US Treasury bills
• commercial paper
• negotiable certificates of deposit
• bankers acceptances

28
RECEIVABLES MANAGEMENT

• The tools of credit policy include
• - _____ (discount, payment period)
• - credit _____ (which customers will receive
  trade credit vs pay cash)
• - _____ policy (treatment of overdue
  accounts)
• Consider the problem on the next slide.

29
Example involving an increase in sales

• Proposed Policy
• terms 2/10 net 30
• salesGross 6 mil
• 60 take discount
• DSO of 22 days
• CostCreditDept25000
• bad debts 3.0

• Current Policy
• terms net 30
• salesGross 5 mil.
• DSO of 35 days
• bad debts 2.0
• CostCreditDept12000
• Var cost 85
• rd 10

30

• If the proposed policy is accepted
• What is the expected change in gross profits?
• What is the expected change in discount costs?
• What is the expected change in bad debts?
• What is the expected change in credit dept. costs?

31

• ?Gross Profit (SN S0)(1 V)
• ?Discounts (DNSNPN D0S0P0)
• ?Bad Debts (BNSN B0S0)
• ?CostCreditDept CostN Cost0

32

• What is the expected change in receivables
  investment associated with the original
  sales?
• What is the expected change in receivables
  associated with the new sales?

33

• ?Int. Exp r (?I)
• r (?IExistingSales (at retail)
• ?INewSales (at cost))
• r(DSON DSOO)(S0/365)
• V(DSON)(SN - S0)/365

34

• What is the expected effect on profit?
• Should the company change to the new credit
  policy, or stay with the old one?

35
Example involving a decrease in sales

• Proposed Policy
• terms net 20
• salesGross 4.5 mil
• DSO of 25 days
• bad debts 1.5

• Current Policy
• terms net 30
• salesGross 5 mil.
• DSO of 35 days
• bad debts 2.0
• Var cost 85
• rd 10

36

• If the proposed policy is accepted
• What is the expected change in gross profits?
• What is the expected change in discount costs?
• What is the expected change in bad debts?
• What is the expected change in credit dept. costs?

37

• ?Gross Profit (SN S0)(1 V)
• ?Discounts (DNSNPN D0S0P0)
• ?Bad Debts (BNSN B0S0)
• ?CostCreditDept CostN Cost0

38

• What is the expected change in receivables
  investment associated with the original
  sales?
• What is the expected change in receivables
  associated with the new sales?

39

• ?Int. Exp r (?I)
• r (?IExistingSales (at retail)
• ?INewSales (at cost))
• rd(DSON DSOO)(SN/365)
• V(DSOO)(SN - S0)/365

40

• What is the expected effect on profit?
• Should the company change to the new credit
  policy, or stay with the old one?

41
ACCRUALS

• Accruals a _____ of funds that _____ be
  manipulated.
• The two major categories of accruals are accrued
  _____ accrued _____.
• Accruals are a _____ source of funds that
  automatically increases with increases in the
  level of business.

42
ACCOUNTS PAYABLE (TRADE CREDIT)

• Accounts payable is a _____ of funds.
• Accounts payable is highly important because it
  is often the _____ single source funds and may be
  the _____ large source of funds to small firms.
• Accounts payable is a _____ source of funds
• AcctPay Pur/365 x APP

43
Example

• A firm faces terms of net 30 on annual purchases
  of 182.5 million. What is its average accounts
  payable balance?
• If purchases increase to 219 million, how much
  additional funding is generated?

44
Cost of Trade Credit

• When discounts are offered, it is typically _____
  to skip the discount.
• The cost of skipping the discount may be measured
  in _____ form or _____ form
• inom disc/(1-disc)365/?days
• ieff 1disc/(1-disc)365/?days 1

45

• The nominal cost _____ intra-year compounding
  while the effective cost _____ intra-year
  compounding.
• If a bank account offers 6 (_____) compounded
  daily, you would actually earn 6.18 (_____) each
  year.

46
Example

• Your supplier offers terms of 2/10 net 30. What
  is the cost of foregoing the discount? (That is,
  when you skip the discount, what annual interest
  rate are you paying for the extended credit?)

47

• If your annual purchases are 182.5 million net
  of discounts, how much of your trade credit is
  free? How much is costly?
• Some firms attempt to stretch account payables,
  but this may damage their _____ and run the risk
  of being _____ by suppliers.

48
SHORT-TERM BANK LOANS

• Short-term bank loans are displayed on the
  balance sheet under the account _____.
• Short-term bank loans _____ a spontaneous source
  of funding, but they are crucial to plugging the
  cash conversion cycle gap.

49

• Short-term bank loans
• - typically have a maturity of _____ year or
  less, with _____-day notes being most common.
• - are formal, involving a _____ note.
• - may be in the form of a line of credit or
  revolving credit
• - may require compensating balances

50
Line of credit vs revolving credit

• A line of credit allows the company to
  automatically _____ up to a maximum amount at any
  time throughout the agreement period.
• If the line is in the form of a revolving credit
  agreement, _____ will be charged on the unused
  portion of the line, but availability of the line
  is _____.

51
Example

• Smith Corp has established a 50 million
  revolving credit agreement at an i-rate of 6 and
  with a commitment fee rate of 1.2. It uses 40
  million of the line for eight months. What are
  its total fees for the year? What is the nominal
  cost of providing the funds used?

52
Methods of Charging Interest

• Assume a 1,000 1-year loan with a stated rate of
  12

53
Simple interest basis

• If interest is charged on a simple-interest
  basis, all interest and principal are paid at the
  _____ of the loan period.
• What is the dollar interest?
• What is the nominal interest rate?

54
Discounted interest

• If the interest is discounted, the interest is
  deducted at the _____ of loan period.
• What is the nominal rate in this case?

55
Compensating balances

• If compensating balances are required, a portion
  of the loan remains in the bank in
  non-interest-bearing form.
• If 20 compensating balances are also required,
  what is the nominal interest rate?

56
Add-on basis

• Assume the loan is to be repaid in monthly
  installments and the interest is charged on an
  add-on basis. What is the nominal interest rate?

57
Summary on methods of charging interest

• Note that discounting interest, requiring
  compensating balances, or charging interest on an
  add-on basis, all _____ the nominal and effective
  interest rates on the loan.
• Charging compensating balances and charging
  interest on an add-on basis are now illegal in
  some states.

58
COMMERCIAL PAPER

• Issuing prime commercial paper is a source of
  funds available only to _____, financially _____
  corporations.
• CP has a maximum maturity of _____ days, to avoid
  SEC registration.
• CP is an _____ promissory note that is marketable
  and backed by a line of credit.

59

• The primary advantage of CP as a source of funds
  is its extremely low _____ to the borrowing
  corporation.
• The primary disadvantages of CP as a source of
  funds are that it is _____ (_____ negotiate an
  extension) and the source _____ during recessions.

60
Independent Reading

• What can be used as collateral on short-term
  loans, and how does the use of collateral affect
  the cost of short-term loans? (p.804)
• What are the advantages and disadvantages of
  short-term financing? (p.801)
• What are the reasons for holding cash? (p. 781)

61
Topics Not Covered

• The Cash Budget (p.782-785)
• Monitoring the Receivables Position (p.791-793)

62
Credit PolicyExample problem 1

• The Boyd Corporation has annual credit sales of
  1.6 million. Current expenses for the
  collection department are 35,000, bad debt
  losses are 1.5, and the DSO is 30 days. The
  firm is considering easing its collection efforts
  such that collection expenses will be reduced to
  22,000 per year. The change is

63

• expected to increase sales to 1.625 million,
  bad debt losses to 2.5, and to DSO to 45 days.
  The variable cost ratio is 75, the marginal tax
  rate is 40, and the opportunity cost of funds is
  16.
• Should the firm proceed to relax its collection
  efforts?

64
Credit PolicyExample problem 2

• The new credit manager of the Vinson Corporation
  was alarmed to find the Vinson sells on credit
  terms of net 90 while industry-wide credit terms
  have recently been lowered to net 30. On annual
  credit sales of 2.5 million, Vinson currently
  averages a DSO of 95 days.

65

• Tightening credit terms to 30 days would reduce
  annual sales to 2.375 million and DSO to 35
  days. Vinsons variable cost ratio is 85, its
  margin tax rate is 40, and its opportunity cost
  of funds invested in receivables is 18.
• Should Vinson proceed to tighten its credit
  terms?